FISCAL ILLUSION FROM GRANTS AND THE LEVEL OF STATE AND FEDERAL EXPENDITURES

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Abstract
The theory of fiscal illusion maintains that local grant receipts will increase the demand for local public goods. This paper extends the fiscal illusion thesis to the federal and state levels. Federal or state grants to localities will increase the taxes levied by the donating agency without permitting an associated increase in direct services. If consumer/voters are largely unaware of intergovernmental transfers, grants will make the federal and state governments appear inefficient and thereby decrease demand for federal and state public goods. The hypothesis is tested and confirmed by using survey data to estimate the impact of grants on the demand for state government expenditures. The fiscal illusion tendency is then used to explain observed shifts in the demand for defense expenditures.

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